Transcript

1.
Financial institutions: converting commercial
mortgages to REO — valuation and accounting
considerations
Real experience. Real perspectives. Real solutions.
Overview
The commercial real estate markets are currently
experiencing unprecedented declines resulting in escalating
mortgage defaults and a sharp spike in Real Estate Owned
(REO) assets held by lenders. An REO asset is a property that
is in the possession of a lender as a result of foreclosure or
forfeiture by a borrower. Taking over the ownership of an
asset is just one of several options that a financial institution
has in managing non-performing loans on commercial real
estate. In fact, REO is often considered a last resort by
lenders after other options such as loan workouts and sales
of the loans are considered; this is because many lenders do
not have the resources and/or experience to manage and
operate the real estate to maximize its value. Nonetheless,
the number of REO assets has increased dramatically
from April 2009 thru December 2009; a trend which may
continue in the foreseeable future.
There are many valuation and accounting considerations
that factor into the decisions that executives at financial
and lending institutions make when converting commercial
mortgages to REO assets. This topic is particularly relevant
in the current challenging economic times as financial
institutions are faced with very difficult decisions related to
their troubled loan portfolios.
Current commercial real estate market and debt
conditions
Commercial real estate market
Over the twelve months from 4Q 2008 to 4Q 2009, the
commercial real estate market has experienced a significant
downturn. As illustrated in the table below, transaction
volume for the five primary property types has decreased by
approximately 22% for retail properties to 76% for office
properties from 4Q 2008 to 4Q 2009.
These figures demonstrate the drastic reduction in sales
activity within the market across these primary property
types. Similarly, property returns have been severely
impacted.
As presented in the following table, annualized long-term
historical returns for commercial real estate fall within
the range of 8% to 10%, whereas returns from 3Q 2008
to 3Q 2009 across these primary property types were
approximately -22%.
Commercial real estate debt
It is estimated that approximately $2.5 trillion in commercial
mortgage backed securities (CMBS) and non-CMBS debt
on commercial real estate will come due between 2009
U.S. transaction volume ($mil)
Property type 4Q 2008 4Q 2009
Percent
change
Office 7,640 1,834 -76.0%
Industrial 3,100 1,120 -63.9%
Retail 3,141 2,445 -22.2%
Hotel 1,005 296 -70.5%
Apartment 4,922 2,901 -41.1%
Source: Real Capital analysis
U.S. transaction volume ($mil)
Property
type
3Q
2008
to 3Q
2009
2Q
2009
3Q
2009
Annual
since
inception
Inception
date
Office -24.50% -6.52% -3.30% 8.20% 4Q 1977
Industrial -22.38% -5.09% -3.94% 9.24% 4Q 1977
Retail -15.78% -3.03% -3.14% 9.35% 4Q 1977
Hotel -26.45% -5.46% -4.47% 8.36% 1Q 1997
Apartment -23.03% -5.13% -3.00% 8.26% 3Q 1984
National -22.09% -5.20% -3.32% 8.91% 4Q 1977
Source: Real Capital analysis

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and 2013. A Real Estate Roundtable report projects that
upcoming debt maturities will exceed $500 billion in 2010
and peak at nearly $600 billion in 2012. These upcoming
debt maturities, combined with the downturn in commercial
real estate values/returns and much tighter underwriting
standards, point to the potential for significant distressed
debt in the near term for financial institutions and possible
further deterioration in the commercial real estate market.
Annual CMBS and Non-CMBS debt maturities
As to be expected, default rates have increased dramatically
and continue to do so. As of December 2008, the level of
leveraged loan debt in default was over $22 billion, which
is an increase of over 500% from the levels experienced in
December 2007 at $3.5 billion.
Although there is distressed debt in the market related to
almost every property type, multi-family and retail loans
have experienced the highest level of delinquencies. Retail
delinquencies may continue to increase substantially as
consumer spending continues to suffer and store closings
and retailer bankruptcies occur. Delinquencies on hospitality
assets may also rise as both business and leisure travel are
projected by several data sources to remain slow in the
foreseeable future. Across property types, development
assets currently have an extremely high level of delinquency,
because the fair value of the underlying collateral may have
declined, there is no current income and in many cases,
there is no projected income for five to seven years.
According to Realpoint Research, delinquencies in Florida,
Texas, and California account for approximately 30%
of CMBS delinquency. Further, the 10 largest states
by delinquent unpaid balance comprise 56% of CMBS
delinquency.
As previously noted, REO is often a last resort for financial
institutions holding non-performing loans on commercial
real estate. As of December 29, 2009, the total dollar
amount of distressed assets for which the mortgage is in
default, the owner is bankrupt, or the property has already
been foreclosed upon in the U.S. was approximately
$170.74 billion. Of this amount, nearly 12%, or $20.65
billion, pertained to REO assets. Many of the $170.74
billion in assets classified as “troubled” may eventually
become REO assets.
The following is a comparison of the information presented
in the above chart over the eight months from the
end of April through the end of December 2009. This
illustrates that the number of distressed assets is increasing
substantially and an increasing number of the assets are
being taken into REO by the lenders. In fact, the carrying
value of distressed REO properties has increased by
approximately 125% over this eight month period.
A geographic breakdown of the distressed and potentially
troubled assets is presented by region below. While the
Southeast region of the United States has the highest
amount of distressed properties including the largest
proportion of properties in lender REO, the Northeast
region has the highest amount of troubled properties. The
Southeast and West regions have the highest amount of
lender REO properties.
Pre-REO planning
Taking a property into REO is often a time-consuming and
complicated process for a financial or lending institution.
The lender should consider many factors, including:
Is the property distressed or is the borrower distressed•
(i.e., is it a bad asset and a good borrower or a good
asset and a bad borrower)?
What are the potential risks of owning the property and•
how can they be mitigated?
Is construction on the property completed or is it•
considered a development asset?
What are the management requirements of the property?•
Does the lender have the resources and experience to•
manage the property in a way that maximizes the asset’s
value?
What are the benefits and costs of outsourcing certain•
aspects of the asset/property management?
What are the short-term capital requirements (including•
dealing with any deferred capital or maintenance
expenditures) to maintain the property and keep it
competitive in the market?
What are the normal operating expenses (e.g., real estate•
taxes, insurance, etc.) to be incurred during the holding
period?
What is the expected timeframe until a sale (holding•
period) to a third-party once the property becomes REO?
Can the anticipated appreciation or depreciation during•
the holding period be projected?
600
500
400
300
200
100
0
2009
CMBS Non-CMBS CRE debt
201320112010 2012
Source: Real Estate Roundtable, Green Street Advisors,
Mortgage Bankers Association, Wells Fargo, Trepp, Bank
of America
0.3 0.7
4
8.4
12.8 13.2
11
4.9
8.8 7.7
3.5
22.1
0
1
2
3
4
5
0
5
10
15
20
25
1997
1998
1999
2000
2001
2001
2003
2004
2005
2006
2007
2008
Par amount outstanding
$billions
Defaultrate(%)
Source: North American Distressed Debt Market Outlook
2009, Debtwire North America (January 2009), Federal Reserve
website

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What are the costs to take the property into REO and•
what are the projected costs to sell the property (e.g.,
advertising, broker’s commission)?
What type of internal controls should be implemented to•
manage risks?
How should the property be accounted for under U.S.•
GAAP?
What type of valuation policy should be implemented?•
What are the tax implications?•
Although all of the items above are important
considerations for a lender considering taking a property
into REO, the accounting and valuation considerations
are highly important to the REO strategy and can have
immediate accounting and reporting implications to the
financial statements of the lender.
Once a lender takes back a REO asset, one of the first
decisions that should be considered is regarding the asset’s
disposition strategy, which determines the classification of
the asset, and in turn, the initial accounting treatment of the
REO. Under an immediate sales strategy, assuming certain
criteria1
are achieved under accounting principles generally
accepted in the United States (GAAP), the REO would be
classified as a “Held for Sale” asset. If the asset doesn’t
qualify for the “Held for Sale” criteria, the asset is classified
as “Held and Used”.
Once this determination of the classification of the REO
is made, the lender would adhere to troubled debt
restructuring rules2
under GAAP and record the REO asset
and remove the related loan from its books. After the
troubled debt restructuring, the lender accounts for assets
received in satisfaction of a receivable the same as if the
assets had been acquired for cash.
REO asset classified as “Held for Sale”
The REO would initially be recorded at fair value less cost to
sell. The lender would record a loss on the cancellation of
the loan asset for any excess of the recorded net investment
in the receivable satisfied over the fair value of assets
received less estimated cost to sell.
The “Held for Sale” classification requires the lender to
report the REO using single financial statement line item
presentation, rather than a traditional operating model
(gross presentation) used by an owner of real estate. Under
the “Held for Sale” reporting presentation, all the related
assets of the REO are grouped into a single asset caption
(“Assets Held for Sale”) and all the related liabilities of the
REO are grouped into a single liability caption (“Liabilities
Related to Assets Held for Sale”) on the lender’s balance
sheet. In addition, if material and meets the definition of a
component under GAAP, the related operations of the REO
would be collapsed and reported as discontinued operations
in the lender’s income statement.
1
ASC 360-10-45-9 through 45-11 Property, Plant, and
Equipment (formerly known as FAS 144 Accounting for the
Impairment or Disposal of Long-Lived Assets)
2
ASC 310-40 Receivables - Troubled Debt Restructurings by
Creditors (formerly known as FAS 15 Accounting by Debtors
and Creditors for Troubled Debt Restructurings)
While the REO is classified as “Held for Sale”, depreciation
of the REO asset is suspended, while interest and other
expenses attributable to the liabilities continue to be
accrued. Legal fees and other direct costs incurred by a
creditor to effect a troubled debt restructuring are included
in expense when incurred.
Once the REO is sold, a true-up of the estimated selling
costs is made in the final determination of the recognized
gain or loss on the sale of the REO asset. Typically, the
related gain/loss on the disposition of the REO would be
reported within the discontinued operations section of the
lender’s income statement.
What happens if the lender decides not to sell the REO in
the near term?
If circumstances arise that previously were considered
unlikely and, as a result, the lender decides not to sell the
REO asset, the asset shall be reclassified as “Held and Used”.
Under GAAP, the reclassified asset is measured at the lower
of its (a) carrying amount before the asset was classified
as “Held for Sale” adjusted for any depreciation expense
that would have been recognized had the asset been
continuously classified as “Held and Used” or (b) the fair
value at the date of the subsequent decision not to sell.
REO asset classified as “Held and Used”
The REO asset would initially be recorded by the lender at
the fair value of the real estate. The lender would record a
loss on the cancellation of the loan asset for any excess of
the recorded net investment in the receivable satisfied over
the fair value of assets received.
Unlike “Held for Sale” treatment, a “Held and Used”
REO asset is accounted for as if the lender purchased the
asset to operate for a period of time. The lender would
generally be required to account for the acquired asset
under the acquisition method of accounting for business
combinations.3
As a result, the lender must recognize and
measure in its financial statements the identifiable assets
acquired and the liabilities assumed related to the REO asset
based on fair value. After the allocation of purchase price is
determined, the REO asset (including its separate identifiable
tangible and intangible assets and liabilities) is depreciated
and amortized. Many accounting estimates are required to
be made by the lender in order to properly account for the
“Held and Used” REO asset. The lender must first allocate
the purchase price to the various identifiable tangible and
intangible assets and liabilities based on their fair values.
In addition, the lender must establish the useful lives of
each of the REO assets in order to properly determine the
related depreciation or amortization charge that would be
recognized in the lender’s financial statements. Similar to
the “Held for Sale” accounting treatment discussed above,
legal fees and other direct costs incurred by a creditor to
effect a troubled debt restructuring shall be included in
expense when incurred.
Besides the initial and ongoing accounting for operating real
estate, the lender should establish internal accounting and
reporting processes, modify or implement a financial system
to record and process real estate related transactions, as
3
ASC 805 Business Combinations

4.
well as establish a comprehensive system of internal control
over maintaining REO assets.
Besides the asset management considerations of REO,
financial institutions should consider the financial reporting
implications of managing REO. Several reporting implications
will likely change the lender’s financial statements. First,
the lender will be required to consolidate the real estate
investment on its books and perform the accounting, as
if it had originally acquired real estate, rather than merely
providing a loan to a borrower. As a result, additional real
estate investment disclosures could be required under GAAP,
thereby expanding the complexity of the lender’s financial
statements. As a result of owning and operating REO assets,
a lender may experience cash flow and earnings volatility.
Such volatility may result from changes in occupancy, rental
rates, incentives provided to tenants, planned or unexpected
capital expenditures, unreimbursed operating expenses and
property impairments.
REO valuation issues
There are a number of valuation issues that financial
institutions should consider when bringing assets into REO.
Institutions typically acquire REO through foreclosure or
deed in lieu of foreclosure after a borrower defaults on
a loan. To adhere with guidance published by the FDIC,
financial institutions should obtain a new or updated
valuation that complies with state law at the time of
acquisition of REO, as well as, the Appraisal Regulation
(12CFR Part 323), Interagency Appraisal and Evaluation
Guidelines. Additionally, many state laws may require
institutions to obtain annual or periodic valuations for each
parcel of REO to determine that any material change in
market conditions or the physical aspects of the property
are recognized. Lastly, upon the disposition of REO, certain
state laws may require appraisals if an institution is selling an
asset or financing the transaction.
Fair value for financial reporting
There are three phases in the life cycle of foreclosed
real estate: acquisition, holding period, and disposition.
For purposes of financial reporting for the REO at both
acquisition and during the holding period, an estimate of
fair value is required.
At acquisition, and if the asset is classified as “Held for Sale”,
the foreclosed real estate should be recorded at the fair
value less estimated costs to sell the property at the time
of foreclosure. This amount then becomes the “cost” or
carrying value of the foreclosed real estate. GAAP defines
costs to sell as “the incremental direct costs to transact a
sale,” which include “broker commissions, legal and title
transfer fees, and closing costs that must be incurred before
legal title can be transferred.
During the holding period, each foreclosed real estate
asset must be carried as outlined above. At the time of
disposition, typically no fair value estimate is required.
Fair value defined
A determination of fair value is necessary to properly
account for REO assets under GAAP. As such, it is important
to understand the definition of fair value and its implications
for financial reporting.
Fair value is defined under GAAP as “the price that would
be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the
measurement date.”4
GAAP also states that an orderly transaction “is a transaction
that assumes exposure to the market for a period prior to
the measurement date to allow for marketing activities
that are usual and customary for transactions involving
such assets or liabilities; it is not a forced transaction (for
example, a forced liquidation or distress sale).”5
Based on
this definition, a valuation specialist should state and justify
the estimated exposure time.
Another provision included in the definition of fair value is
the concept of an exit price. Under GAAP, “the transaction
to sell the asset or liability is a hypothetical transaction at
the measurement date, considered from the perspective of a
market participant that holds the asset or owes the liability.
Therefore, the objective of a fair value measurement is to
determine the price that would be received to sell the asset
or paid to transfer the liability at the measurement date
(an exit price).”6
It is important to note that fair value does
not incorporate transaction costs. As such, for purposes
of establishing the carrying value of a foreclosed property
for financial reporting purposes, the costs to sell should
be estimated by a valuation specialist or other qualified
professional and deducted from the concluded fair value
estimate.
Other important considerations in the definition of fair
value are (1) a fair value measurement assumes that the
transaction to sell the asset occurs in the principal or
most advantageous market for the asset; (2) the fair value
should be based on the assumptions of market participants
defined as “buyers and sellers in the principal (or most
advantageous) market for the asset…”7
; and (3) a fair value
measurement assumes the highest and best use (the use
of an asset that maximizes its value) of the asset by market
participants.
Valuation techniques
There are three generally accepted valuation techniques
for estimating the fair value of real estate: the market
approach, income approach, and cost approach. Fair value
accounting guidance states that “valuation techniques
that are appropriate in the circumstances and for which
sufficient data are available shall be used to measure
fair value.”8
This guidance indicates that in some cases a
single valuation technique will be appropriate and in other
cases multiple valuation techniques will be appropriate. If
multiple valuation techniques are applied, the indications of
value derived from each technique should be weighted and
reconciled appropriately.
4
ASC 820 Fair Value Measurements (formerly known as FAS
157 Fair Value Measurements)
5
ASC 820 Fair Value Measurements
6
ASC 820 Fair Value Measurements
7
ASC 820 Fair Value Measurements
8
ASC 820 Fair Value Measurements

5.
Financial accounting
In some cases, a financial institution acquiring an REO asset
may be required to account for the tangible and intangible
components of the asset in accordance with accounting for
business combinations.9
Tangible components of commercial real estate typically
include:
Land;•
Building;•
Site Improvements; and•
Tenant Improvements.•
Intangible components of commercial real estate may
include:
Foregone Rent and Expenses;•
Unamortized Leasing Commissions;•
Unamortized Legal Expenses;•
Above Market Leases;•
Below Market Leases;•
Customer or Tenant Relationships;•
Management Contracts; and•
Other.•
Regulatory considerations
Based on information provided in the Comptroller’s
Handbook (Section 219) published by the Comptroller of
the Currency; Administrator of National Banks as well as
information provided by the Office of Thrift Supervision
(“OTS”), there are several regulatory issues to consider
with REO properties. The following are some of the more
relevant considerations.
In accordance with 12 CFR 560.172, a savings association
must appraise each parcel of REO at acquisition. As such,
upon transfer to REO, fair value must be substantiated
by a current appraisal prepared by an independent,
qualified appraiser. This requirement is waived when the
entire property is recorded at or below the lower of 5%
of the bank’s equity capital or $25,000. Additionally,
the requirement can be deferred three months after the
bank takes title when the bank can document reasonable
expectation of a sale other than in a covered transaction.
Throughout the holding period, prudent management
policy dictates the timing and frequency of appraisals.
An REO property can generally not be held by a financial
institution for longer than a period of five years. In certain
instances a bank may be permitted to hold the REO up to
an additional five-year period beyond the original one if
approved by the OTS.
An appraisal for an REO property should estimate the cash
price that might be received upon exposure to the open
market for a reasonable time, considering the property
type and local market conditions. When a sale within 12
months is unlikely, the appraiser must discount all cash
flows generated by the property to obtain the estimate of
fair value.
9
ASC 805 Business Combinations (formerly known as FAS
141R (revised 2007), Business Combinations)
Conclusion
The decision by lenders to take back real estate is not as
simple as one might expect when a borrower is in default
on their mortgage note. Often times, those decisions
become difficult and complex given that many financial
institutions have not recently been active in owning and
operating real estate. If the lender decides to hold and
operate REO assets, it should consider carefully developing
a comprehensive strategy for acquisition, operation, and
disposition of its REO inventory.
Prior to taking back a REO asset, financial institutions should
consider fully evaluating the risks and rewards of owning
real estate. When a lender takes possession of the loan
collateral, the lender typically intends to maximize the value
of the REO asset through efficient operations to reposition
the asset, and/or realize additional incremental value
through longer term appreciation. In these volatile market
conditions, the decision to hold and operate an asset could
be a winning strategy for the lender if future disposition
of the property results in recovery of previously recognized
losses on the loan or generates a gain greater than if it had
held the original mortgage note. In other cases, the lender
may decide that an immediate disposition strategy is best to
extract immediate cash proceeds from the REO asset, rather
than taking on additional risks as an owner of real estate.
These critical decisions multiply when financial institutions
take back portfolios of REO assets. Either strategy will likely
result in significant accounting, valuation and financial
reporting impacts on the financial statements of the lender.
As the U.S. economy climbs out of the global recession,
a growing number of investors will likely take advantage
of new investment opportunities in areas that serve as a
bridge or substitution to the existing capital markets. A
number of sources indicate that investors have seen a rise of
new commercial real estate investment funds, initial public
offerings, nonlisted blind pool registrations, asset recovery
funds, and mortgage REITs, which could serve to augment
the existing CMBS market and create an additional source
of purchasers of mortgage-backed investments. These funds
could also serve as the eventual buyers of REO assets from
financial institutions when these lenders execute their REO
disposition strategy.
Matthew G. Kimmel (mkimmel@deloitte.com ) is
a principal at Deloitte Financial Advisory Services LLP
based in Chicago and serves as the national valuation
leader of the real estate industry practice.
Brian D. Ruben (bruben@deloitte.com) is a partner at
Deloitte & Touche LLP and serves in the national real
estate industry practice based in Chicago.
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Touche LLP and Deloitte Financial Advisory Services LLP are not,
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